Covered call

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Payoffs and profits from buying stock and writing a call.

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

These long position in the underlying instrument is said to provide the "cover" as they can be delivered to the buyer of the call if he decides to exercise.

Writing a call generates income, in the form of the premium paid by the option buyer, and if the stock price remains stable or increases the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines the net position will likely lose money.

Since in equilibrium the payoffs on the covered call position is the same as a short put position, the price (or premium) should be the same as the premium of the short put or naked put.

[edit] Examples

An investor has 500 shares of XYZ stock, valued at $10,000. He sells 5 call option contracts for $1500, thus covering a certain amount of decrease in the XYZ stock (i.e. only after the stock value has declined by more than $1500 would the investor lose money overall). Losses can not be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and the seller (writer) will keep the money paid on the premium of the option, thus reducing his loss from a maximum of $10000 to $10000 - (premium).

This "protection" has its potential disadvantage in that the investor (option writer) may be forced to sell his stock below market price at expiry, or must buy back the calls at a price higher than he sold them for.

If before expiration the spot price does not reach the strike price, the investor might repeat the same process again if he/she believes that stock will either fall or be neutral.

A call option can be sold even if the option writer doesn't initially own the underlying stock. If XYZ trades at $33 and $35 calls are priced at $1, then an investor can purchase 100 shares of XYZ for $3300 and sell one (100-share) call option for $100, for a net cost of only $3200. The $100 premium received for the call will cover a $1 decline in stock price. The break-even point of the transaction is $32/share. Upside potential is limited to $300, but this amounts to a return of almost 10%. (If the stock price rises to $35 or more, the call option holder will exercise his option and the investor's profit will be $35-$32 = $3). If the stock price at expiry is below $35 but above $32, the call option will be allowed to expire, but the investor can still profit by selling his shares. Only if the price is below $32/share will the investor experience a loss.

Payoffs from a short put position, equivalent to that of a covered call

To summarize:

[edit] Marketing

This marketing strategy is sometimes categorized as "safe" or "conservative" and even "hedging risk" as it provides high income and its flaws are well known since 1975 when Fischer Black published his theory in "Fact and Fantasy in the Use of Options. According to Reilly and Brown (2003); "to be profitable, the covered call strategy requires that the investor guess correctly that share values will remain in a reasonably narrow band around their present levels." (p. 995)

In recent years, the interest in covered call strategies has been enhanced by two developments according to the article “Buy Writing Makes Comeback as Way to Hedge Risk.” Pensions & Investments, (May 16, 2005): (1) in 2002 the Chicago Board Options Exchange introduced the first major benchmark index for covered call strategies, the CBOE S&P 500 BuyWrite Index (ticker BXM), and (2) in 2004 the Ibbotson Associatesconsulting firm published a case study on buy-write strategies. After mid-2004, many new covered call investment products were introduced.

[edit] References

• Chicago Board of Options Exchange [1]
• Screen market for covered calls [2]
• Covered Call Rank [3]